Book Review: 'Flash Boys' by Michael Lewis

High-frequency traders use dedicated data cables and specialized algorithms to trade milliseconds ahead of the rest of the market.

By

Philip Delves Broughton

March 31, 2014 7:29 p.m. ET

In the spring of 2007, Brad Katsuyama, a rising New York banker at the Royal Bank of Canada, realized something was funny with the markets. He was trying to buy 10,000 shares of Intel, offered at $22. But the moment he pushed the buy button, the offers vanished. It was as if the market were reading his mind and adjusting the prices just before he made his trade. He wasn't far off.

Wall Street has always attracted more than its share of scammers and bandits. Today's prime exemplars, argues Michael Lewis in "Flash Boys," are high-frequency traders—or HFTs—who nickel-and-dime investors by exploiting a technological arsenal of servers, fiber-optic cable and microwave transmission towers to trade milliseconds ahead of everyone else in the markets. They have turned the exchanges into a computerized monster churning up unprecedented market volatility. All this has happened since the 2008 financial crisis, a period in which the markets were supposed to have been under closer scrutiny than ever.

Back in the day, if an investor wanted to buy or sell a stock, he would call a broker, who would find a way to execute the trade as efficiently as possible by talking to other human beings. The arrival of computerized exchanges slowly eliminated people from the process. Instead, bids and offers were matched by servers. The shouting men in colorful jackets on the exchange floors became irrelevant. In theory, this meant that the cost of trading fell and that the markets became more efficient. But the effects of technology are rarely so simple.

ENLARGE

wsj

Flash Boys

By Michael Lewis (Norton, 274 pages, $27.95)

In 2002, 85% of all U.S. stock-market trading happened on the New York Stock Exchange and the rest mostly on the Nasdaq. By early 2008, there were 13 different public exchanges, most just stacks of computer servers in heavily guarded buildings in northern New Jersey. Now, if you place an order for 1,000 shares of Microsoft, it pings from exchange to exchange claiming a few shares at each stop, seeking the best price until the order is completed. But the moment that it hits the first exchange, the HFTs see it, and they race ahead to the other exchanges, buy the stock you want, and sell it back to you for fractionally more than you hoped to pay. All in a matter of milliseconds, millions of times a day to millions of investors—your grandmother and hedge-fund titans alike. These tiny but profitable trades, Mr. Lewis writes, add up to big profits for firms like Getco and Citadel. He cannot put a hard number on the size of the industry, suggesting only that many billions are involved.

If this sounds like the old Wall Street scam of front-running the market, that's because it is. Except, in this case, it is entirely legal. Indeed, Mr. Lewis suggests, the strategies of high-frequency traders were the unintended consequence of well-intentioned regulation. Back in 2005 the SEC, in an effort to ensure greater fairness for investors, changed a key rule. Once, brokers had to perform the "best execution" for their clients. This meant taking into account factors such as timing and likelihood of completing the transaction, as well as price. Now they have to find the "best price," as determined by regulators' own creaky computers, scanning the bids and offers available on the various exchanges. But traders could do the same analysis more quickly using their own networks, and make trades in the milliseconds between an investor placing an order, the SEC establishing the best price and the broker executing the trade.

A decade later, the HFTs do such big business that they have begun to influence the operations of the exchanges that depend on them. The exchanges take fees from the HFTs for access to the flow of orders, as do investment banks that run their own private exchanges, called "dark pools." Exchanges bend their rules to the bidding of the high-frequency traders: The HFTs wanted an extra decimal place added to stock prices, for instance, so they could mop up every thousandth of a penny in price fluctuations; the exchanges obliged. "By the summer of 2013," writes Mr. Lewis, "the world's financial markets were designed to maximize the number of collisions between ordinary investors and high-frequency traders—at the expense of ordinary investors."

"Flash Boys" is not as larky as "Liar's Poker" (1989), Mr. Lewis's memoir of working at Salomon Brothers during the lead-up to the 1987 crash, or as accessible as "The Big Short" (2010), his jaw-dropping take on the subprime meltdown. It may end up more important to public debate about Wall Street than either, however, in exposing what one of his central characters calls the "Pandora's box of ridiculousness" that financial exchanges have become.

Mr. Lewis wants to argue, though, that the markets are not just ridiculous, but rigged. The heroes of this book are clear: Mr. Katsuyama eventually assembles a team of talented misfits to create an HFT-proofed exchange called IEX, where a price is a price is a price. It's backed by leading hedge funds and banks (and Jim Clark, the co-founder of Netscape and the subject of Mr. Lewis's 1999 book, "The New New Thing"). Mr. Lewis gives the reader extensive insight into how his heroes see the market, but the alleged villains of the piece—HFTs themselves—are all but silent in their own defense. "Flash Boys" is a decidedly one-sided book.

Yet there are reasonable arguments to be made that the frenetic trading by HFTs leads to greater liquidity and more efficient pricing. Or, God forbid, that they are not nearly so harmful to investors' returns as Mr. Lewis makes out. Their rise has coincided with a historic bull market. It is not hard to imagine a different book by Michael Lewis, one celebrating HFTs as revolutionary outsiders, a cadre of innovative engineers and computer scientists (many of them immigrants), rising from the rubble of 2008 and making fools of a plodding financial system. "Flash Boys" makes no claim to be a balanced account of financial innovation: It is a polemic, and a very well-written one. Behind its outrage, however, lies nostalgia for a prelapsarian Wall Street of trust and plain dealing, which is a total mirage.

Mr. Delves Broughton's latest book is "The Art of the Sale: Learning From the Masters About the Business of Life."

The reviewer seems to willingly misinterpret what the author longs for. From my read, it is not, " a prelapsarian Wall Street of trust and plain dealing." Rather it's a modern exchange that is not bilking the buyer with a layer of unnecessary and unwanted "service" that users the buyers action against him or herself to make a profit and ultimately raise the price of all trades. There is no indication at all that HFTs lead to "more efficient pricing."

In no part of the book does Mr. Lewis ask to turn the clocks back. Not unless you want to interpret comparing the old with the new. Nor does the solution that the protagonists develop - and Mr. Lewis endorses - look backwards to the good old days for the answer.

So, the basic gist of this piece is "sure, cheating goes on, but WSJ editors rillie rillie like this set of cheaters, so just shut up and live with it" ???

These guys have found a way to do in the financial industry precisely what those in the entertainment industry do: ply a trade in which the the quantity of consumers is enormous, and are quite content with the millions/billions that come from taking a few bucks from each, that they'll never miss. Entertainers generally need acting/singing/dancing/whatever skills, and flash trades need network programming skills. Both are equally despicable.

"Yet there are reasonable arguments to be made that the frenetic trading by HFTs leads to greater liquidity and more efficient pricing. Or, God forbid, that they are not nearly so harmful to investors' returns as Mr. Lewis makes out."

Liquidity for whom? All of this inside baseball info that delves into the inner workings of Wall St makes for good reading; however, we are talking about a small sliver of society that still tries to rationalize behavior inimical to society as a whole. Tom Wolfe described the bond market as nothing more than taking "golden crumbs" from a huge tasty cake that is passed between buyers and sellers. The bonds (and the value they added to society) have already been issued. Yet, bond speculators continue to buy and the sell the bonds. There is no value added to them other than a few ticks on the stock ticker. A 64th of a penny difference in price could yield a nice $100,000 profit for some bond salesman.

We've seen this "non-value" added effect in the stock market as a whole. Prices continue to go up despite anemic performance of the national (and to a large degree international) economy as a whole. Since 2009, the DJIA has added almost $4 trillion in new wealth to the US economy; yet, the US economy has had its weakest 5 year performance since 1933. All of this new wealth the DJIA has added remains bottled up in two to three dozen investment houses. Some economists explain that the $3.7 trillion in QE the Fed issued since 2009 has gone straight into the stock and commodities markets - where it will remain until interest rates go up and QE ends.

In other words, Lewis shows us how billionaires are stealing from millionaires. Imagine that.

The reality is that, while HST might not do any (or much) harm, it certainly serves no useful purpose in the functioning of modern capital markets. If the regs force HST to take a few steps back, the markets will not be the worse for it.

"Dark Pools" are a much bigger threat in my opinion. Creating parallel trading pools of stock where the connected get in and everybody else packs sand is ripe for manipulation of stock prices on the public markets and to the benefit of the dark pool participants. The very first news article announcing the formations of dark pools set of alarm bells with me and I absolutely could not believe that the SEC was allowing them to happen.

I was a broker for many years, and I found that stating a price for a stock at which to buy or sell rather than placing a market order was the best way to go. Trading, whether in stocks and bonds or tulips is ultimately humanly controlled, and we know that humans, even with their complicated technology, are fallible and/or corrupt.

Consider placing buy orders for a desired stock in small increments, placed serially, until the entire desired quantity is reached. You could do it online by the seat of your pants, or brokers could have software that divied up the whole into increments that matched the sell orders available on the first exchange. The sales may complete without ever going to the second exchange.

Will it satisfy the need to handle volume of orders under tight timeframes? No. But it could cut the income of the HFTs that wouldn't even react to small order quantities unlikely to skip down a path of exchanges to assemble a large quantity in bite-sized available pieces.

They may get away with it anyway, but you do have to TRY to spike naughty little children.

The hype about this "novel" as called on CNBC today should collect as much dust as the book on store shelves. Anyone that has read or heard any of the "rigged market" over traditional market traders, scammers, and book makers is not seeing that that has always been part of "the market". And the rumor mill. Also anyone who has been an investor for more than a decade can remember the high cost of a broker for a simple 100 share trade, that the priced was quoted in 1/8ths, yes 12.5 cent increments, and this guy is bellowing over a penny or thousandths of a penny electronic kiting. Remember that it's now fabulously easy for an individual to buy a company's stock even if it happens to be in Peru or Nigeria if it has an accessible listing, try that over the phone for a penny. More distraction hogwash from our media.

If you're sitting at home trying to run with the big dogs as a day trader, then this stuff probably matters. If, on the other hand, you're investing methodically to accumulate wealth for the long haul, it's hard to get excited over fractions of pennies.

trading on the NYSE before 2007 was actually far worse than the current system.The NYSE specialist would often take 30 seconds to execute market orders, and they would move the market 1/8 before filling the order. Today traders are executed in under half a second and complain if they move the market 1 penny.

HFT traders hold positions for an average of 5 seconds. These firms are trying to earn half a penny per trade. They have very little impact on the typical investor. The system is much better than 10 years ago.

Technological advancement invariable outpaces the ability of man to detect all ramifications. Catch up is needed to correct this obvious legal scam. Mr. Lewis's business is to sell books which does require him to hype the issue a bit. In any event, he is doing the public a service.

The "liquidity" argument that HFT's provide is a joke. The whole business is predicated on being able to pull your order before it gets executed, sniff out the buy/sell interest, and front-run ahead of it. Limit their ability to pull orders a milisecond before execution and then let's see how much "liquidity" they provide. All that said they are just playing by the rules allowed by the exchanges. Change the rules.

High frequency trading adds a huge amount of volume to the market. That is a real positive to the small investor who is trying to sell thinly traded stocks. We are much more likely to get, close to the amount that we originally hoped to get.

Only huge investors are affected in any significant way. If I make a 20k sale or purchase, HFT might cost me a dime. If I submit to sell a larger number of shares, say 5000, as the stock is declining, with pre HFT liquidity, it would have likely sold, a few hundred at a time and by the time, all was sold, the price could have been substantially lower. With HFT, it is much more likely that those 5000 shares will sell quite quickly.

What a pathetically thin article. Let's talk about some of the undeniable stuff going on. Under SEC regs, you're not supposed to make a bid without intending to go through with it. However, the SEC only regulates down to the thousandth of a second (I believe that is correct) and the HFT machines have precision about a thousand times that. So the HFT machine makes bids, but cancels them before the SEC time threshold.

The proper solution, it seems to me, is to synch all trading activity on the SEC threshold of regulation and then prosecute the stuff out of the guys submitting bogus bids.

Back in the 1970s if you dumped an order on the exchange to sell 1000 shares of a thinly traded stock, you could push down the price by 10%. The specialist would execute 100 at the bid and then anything else came off the book, so we learned to split the order into smaller pieces and feed them out a little at a time. How is it any different now? The article talks about pushing a button to buy 10,000 shares of Intel and having it affect the market.

Not all that long ago there were VERY profitable firms that Bought/Sold US debt with a commission of .25Cents per $1000....that was whittled down, via competition and computers, to almost Zero and those VERY profitable firms and wealthy bond brokers have gone the way of the Polaroid Land Camera...It was a very bad thing for some....a very good thing for the masses....That someone still can eke out a profit at a .0001of a share is to be applauded, not condemned.

Determining a trade price by whatever negotiation means humans wanted to use was always open to manipulation which is what one of the purposes of the "pit" was. That is, if you were trying to pull off some sort of scam in the presence of other traders who soon understood the nature of your scam, they would shut you down, not because they were particularly offended by it but because whatever scam was being used threatened the rational for the stock exchange and their own means of extracting an "accepted" commission rate.

Now with this high speed trading scam that only other high speed computers can track it further takes humans out of the loop. Some argue "so what", the scam only involves minuscule amounts that are invisible to the individual investor and only become worth anything when done over billions of trades. That's probably true. The problem with it all, though, is that the market depends on the trust from clueless investors to provide the money for them to feed on particularly when it's on one of its irrational exuberance runs as it is now.

This sucker, err, I mean investor money continuing to enter the market since Yellen says it's still the only game in town is what the market makers feed handsomely from. Without it the markets will have only have various degrees of scammers performing trades which will would soon result in the whole system collapsing.

In the end all this high speed scamming amounts to is just another example of the inherent corruption in the market which after all produces nothing more than a price for a trade followed by some column entries for which it charges a service fee.

Michael Lewis writes well and infuses his work with well honed irony, too bad it increasingly giving way to polemics and a superiority complex with regard to his topic. The financial markets have been very, very good to him....

How can one market entity having market information before other market participants be fair? They (the HFTs) have an advantage and they use it. If HFTs can have multiple trading accounts and outlets, they can trade with themselves to create market movement, front run orders, and see orders first as they come into the market. The algorithms the powerful computers have take adantage of this in terms of price other market particpants are getting. It's not that complicated, but very effective.

If the technology is there then it will be used and it should not be illegal. In this case it was algorithms, speed and powerful computers/servers. The problem I have is that it should have been made public. To me this is no different than insider trading. The traders that knew how to use this technology tried to keep it a secret as long as they could. The markets are in theory are supposed to be fair and transparent. I would venture to guess that's Lewis's point.

Yawn, yawn, yawner. There are only two thin examples, not too clear, no dollar figures. Mostly fiction? I would like to know what is the dollar figure that these people are writing about. As a book, I would rather like to know about the 17 trillions that everybody have forgotten, and understand who will pay and how much will they cost. Or about so many other expensive projects. For example, uncovered retirement contracts, who is going to pay for them? How far can it go? There are so many things that matter. Maybe I’ll read again The Black Swan and also I may thumb through the International page. Or a book about the taxes: until they reach the destination, how much does it get lost?

Key sentence of the entire article "Indeed, Mr. Lewis suggests, the strategies of high-frequency traders were the unintended consequence of well-intentioned regulation." This sentence could be written about practically every piece of regulation the government has passed in the last 50 years, or longer.

"In the spring of 2007, Brad Katsuyama, a rising New York banker at the Royal Bank of Canada, RY.T +0.40% realized something was funny with the markets. He was trying to buy 10,000 shares of Intel, INTC +0.02% offered at $22. But the moment he pushed the buy button, the offers vanished. " Disappearance of the quotes on multiple exchanges after an order is filled on one exchange is only an indication of market efficiency. This was not a retail trade, and none of the liquidity providers intended to let RBS buy as much as it wanted at the displayed price. If they had done that, those liquidity providers would never have been able to get out of position without a loss. So, if they are quoting 4,000 shares on each of three exchanges, and they see the quote taken on one of the three, the other two need to adjust to reflect the new market price. That needs to take place quickly. Prior to 2001, RBS would have given the whole trade to one human market maker who would have taken a profit of about $.25/share on this. RBS is much better off than before 2001, and the fact that they cannot get the same price as a retail buyer who buys under 4,000 shares at a time is simply good economics.

Agree. I've never placed an order that was not a limit order. To do so otherwise allows someone else to take your price and adjust it to their benefit. That is exactly what the author is claiming HFTs are doing.

But if you're a big investor who turns large trades every week, this is no joke. You're losing money to some jerks whose only service is to buy a stock a millisecond ahead of you by virtue of their software, not their well calculated bet on products and services. This has nothing to do with free markets. This is simply a clever form of legal theft by weasels.

You don't get, John. High frequency trading steals from every investor who has owns a mutual fund or invests through a 401(k). They are stealing fractions of a cent on hundreds of millions of shares every day while providing no redeeming economic result. The best analogy I can think of is knowing the result of a horse race before the news reaches the betting parlor. The regulators have allowed this legal front running for years. They just didn't bother with it, until the publicity got too great for them to ignore. They should be held accountable as well.

The issue is that an order is routed to multiple exchanges to try to get the best price. If the trade is entered in Manhattan and hits the closest exchange 0.1 millisecond later it becomes public knowledge at that instant as it is published on that exchange. The problem is it may take 0.5 millisecond to reach 5 other exchanges in NJ via normal channels and the HFTs have faster systems in place to read the public order on the first exchange and then route it via fiber straight to a server they have sitting right at the other exchanges within 0.3 millisecond so they can front run. But they are technically doing it on public info as already made public at exchange #1.

...sounds to me that if you trade with yourself it's a bit like financial masturbation. I buy 100,000 sha of XYS at 10.000001 and sell it back to myself at 10.0000011....and buy it again at... ...etcetera...That, Sir, ain't gonna work.

"Indeed, Mr. Lewis suggests, the strategies of high-frequency traders were the unintended consequence of well-intentioned regulation. Back in 2005 the SEC, in an effort to ensure greater fairness for investors, changed a key rule. Once, brokers had to perform the "best execution" for their clients. This meant taking into account factors such as timing and likelihood of completing the transaction, as well as price. Now they have to find the "best price," as determined by regulators' own creaky computers, scanning the bids and offers available on the various exchanges. But traders could do the same analysis more quickly using their own networks, and make trades in the milliseconds between an investor placing an order, the SEC establishing the best price and the broker executing the trade."

Apparently the government has stood in the way of this technology being available to everyone. Another example of "the road to hell is paved with good intentions."

It's so easy to manipulate the price that I've often wondered why limit orders are not the norm. It requires patience from both the broker and the client. Maybe that's just something that occurs in human nature infrequently. Those who practice it are rewarded for their wisdom.

The scam clearly depends upon being able to respond before the buyer can comply with government regulation to determine the "best price," which makes it insider dealing and constitutes fraud for all the same reasons it was wrong for collusion to take place between individuals prior to filling the customer's order at an inflated price.

It is clearly theft by technology and can easily be prevented by removing the added decimal place, perhaps even going so far as to limiting price two, certainly no more than three decimal places and requiring responses be delayed a full second or two until the order has reached all the exchanges so that a customer can get the actual best price, rather than an artificially inflated one.

This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.